Decline in the Effectiveness of Accounting Information A Logical ... · The useful accounting information must be both of reliability and of relevance. The reliability and relevance

ISSN: 2306-9007 Jiandong, Jiao & Miao (2013)

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Decline in the Effectiveness of Accounting Information

A Logical Analysis of Divergence Between Goal and Reality

BAI JIANDONG School of Economics and Management, Northwest University,

Xi’an, Shaanxi Province, China, 710127

TANG JIAO School of Economics and Management, Northwest University,


Email: [email protected]

Tel: 15191884497

YANG MIAO School of Economics and Management, Northwest University,


Abstract

The decline in the quality of accounting information in the special market environment of China is a common

objective phenomenon. But because of the lack of the empirical data analysis, the traditional explanations for

this phenomenon are limited to some fact determination or empirical judgment. Based on such fundamental

principles as knowledge constraint, hypothesis of rational man, and insider control, this paper employs a logical

empirical approach to establishing the logical empirical hypothesis and logical empirical model by selecting

four kinds of factual evidence, namely, knowledge, cost, interest, and collusion. Through the proof technique of

logical reasoning, this paper verifies the existence of the logical empirical hypothesis, and conducts the analysis

of the factors affecting the decline in the quality of accounting information and the process in which these factors

operate. To directly show the shocks to the accounting quality from the affecting factors, certain models are

constructed, and the conclusion of this paper is presented.

Keywords: Quality of accounting information, Knowledge constraint, Hypothesis of rational man and Collusion.

Introduction

Along with the social-economic development, accounting has become the information system that provides

various useful information to the users with different information demand in their decision making. Given

the fact that the accounting objective is defined as the usefulness to decision making, the characteristics of

the quality of accounting information are those that make accounting information useful to decision

making, However, in the special market environment of China, the widespread existence of a set of erosive

variables has result in the poor quality of accounting information and thus the decline in the effectiveness

of accounting information. The above judgments are made on the basis of four fact variables that are closer

to the truth, namely, lack of knowledge preparation, interest or tax shock, cost analysis, and collusion of

interest community. Because of the widespread objective existence of these fact variables, the quality of

accounting information in its real state is always below the standard of the quality of accounting

information. Moreover, the shock to the quality of accounting information from the accounting

environment further widens this gap.

Significance of the study: This paper develops and tests two propositions: 1.In using accounting

information for decision making, the users should be prudent and aware of the unavoidable errors in the

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accounting information, including human error and other errors. Therefore, the comprehensive judgment of

the account information should be made by taking other relevant information into consideration; 2. With

respect to the empirical study practice in the accounting research, the conclusions of the empirical studies

should be made in a prudent and reserved way before the reliability and objectivity of the relevant

parameters of accounting research have been validated.

Theoretical Framework

Goal Orientation and Realistic Constraints

Goal Orientation of Accounting

By reference to the definition of the term “quality” as given in the Quality Management and Quality

Assurance-Vocabulary issued by the International Organization for Standardization in 1994, the quality of

accounting information can be defined as “the set of characteristics of the accounting information that gives

it the ability to satisfy express and implicit needs”. (Xiao, 1988).This is a relatively broad definition, which

encompasses all connotations of the usefulness and compliance of accounting information. And the other

goal orientation of accounting is a set of quality characteristics of accounting information as prescribed by

the existing accounting standards.(e.g. reliability, relevance, understandability, comparability, substance

over form, materiality, prudence, and timeliness) (Kong,2006).This set of quality characteristics represent

the measurement standards of the quality of accounting information for meeting the users’ need for account

information in their decision making process, and are the qualitative constraint of the accounting

information system on the accounting information for meeting the goal of accounting.

The former definition of quality is too abstract to be grasped, while the latter also has the problem of

having too many quality standards that are not coherent, in particular, the reliability and relevance can

never be fully compatible with each other. Though the quality standards of accounting information are by

no means perfect, the author of this paper still maintains that the accounting information is the essential

currency signal in the market economy, and the timely and accurate currency signal is the most important

and essential condition to guide the capital flow and the rational allocation of capital.

The goal of accounting is the expected state that people strive to achieve. In the process of achieving this

goal, people are fettered by a series of negative factors such as bounded rationality, calculation of gain and

loss, and interest interference. In particular, in the different accounting environment, these negative factors

will make different impacts.

The existing quality standards of accounting information are based on reliability and focused on relevance

and also take other evaluation criteria. The reliability requirement addresses the problem of the objectivity

of accounting information, while the relevance requirement addresses the problem of the usefulness of

accounting information for decision making. Without reliability, it would be impossible to maintain the

quality of accounting information. Lack of relevance, the economic essence of the quality of accounting

information would be lost. For this reason, reliability and relevance are the equally important

characteristics of the quality of accounting information. The useful accounting information must be both of

reliability and of relevance. The reliability and relevance are closely linked and jointly affect or determine

the usefulness of accounting information (Weng, 2004).

Realistic Constraints

The desired value of the quality of accounting information is to meet the users’ needs for making economic

decisions to the maximum extent. In the real world situation, however, the desired value of the quality of

accounting information will be restricted and interfered by various subjective and objective factors, thus

causing the real level of the quality of accounting information below the desired value. These constraint

factors include:

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Knowledge Shock

The constraint of knowledge is reflected in two aspects: 1. The incomplete knowledge of the providers of

the quality standards of accounting information: This constraint condition is a natural attribute. According

to the bounded rationality theory, the people’s cognitive level is limited because of two reasons: one is that

the environment is complex. In the form of non-personal exchange, people face a complex and uncertain

world. The level of uncertainty increases along with the increase in the number of transactions, and thus the

information is more incomplete (Simon, 2004); the other one is that people’s computational ability and

perceptual ability are limited, and no person could be omniscient; 2. The recipients of accounting

knowledge: As there are numerous accounting practitioners with different levels of expertise and

experience and they understand the ever-changing accounting knowledge and conduct accounting treatment

according to their expertise levels and experience, the results of the accounting treatment inevitably vary

among these practitioners. To sum up, these double knowledge constraints lead to the gap between the

desired value and the actual value, with the uneven characteristics.

Interest Shock

Analysis from Perspective of Conflict

From the perspective of social conflict theory, conflict refers to a tension state that is caused by the

incompatible interest objectives, judgment of gain and loss or disagreement on gain and loss of the different

interest subjects (Bu, 2005).The resulting interest constraint refers to the impact of the inconsistency of the

interests of accounting policy-makers and those of the implementers of accounting policy on the quality of

accounting information. In China, the accounting policy-makers have their specific interest inclination and

political inclination of ensuring the growth of fiscal revenues. As an interest group, the motivation of the

government and government officials to participate in political activities is to maximize their own interests

(Bai, 2002).In contrast, the implementers of accounting policy tend to maximize the corporate interests and

management interests. Therefore, the interests of these two groups are deviated and from each other and in

conflict with each other. Even though the objective of the implementers of accounting policy lowers to the

sustainable business operations, the direct conflict of interest of these two groups is unavoidable.

The conflict of interest between the accounting policy makers and implementers is primarily caused by the

unilateral supply of accounting policy. The centralized policy supply mechanism under tradition system is

indeed superior to the policy formation mechanism through bargaining in terms of efficiency (Bai,2012),

but in the process of formulating accounting policy the pursuit of efficiency function would inevitably lead

to the loss of reliability (degree of collective consensus)(An & Xi,2004). In addition, as the accounting

policy by its nature is a criterion of the appropriation of interests, and the supply of accounting policy lack

of the degree of collective consensus does not have the attribute of rigid constraint, two negative

consequences, namely, game playing within the rules and institutional patching, would occur as a result of

the accrual rules and the policy program options limited by the uncertainty of economic activities. This

would result in the game playing in the process of implementing accounting policy and thus affect the

quality of accounting information.

Analysis from Perspective of Game Theory

Whether analyzing from the perspective of individual rationality, or from the standpoint of positivism or

the observable facts, in respect of the essential nature of the appropriation of interests relating to the

accounting information and the results of earnings it discloses, the state interests and corporate interests, the

corporate interests and insider interests, the sustainable business operations and opportunistic selection, and

the revenue accumulation and interest sharing obviously reveal the characteristics of non-cooperative game.

This non-cooperative game is primarily reflected in the sharing of tax between the State and the enterprises.

According to the empirical research findings presented by professor Watts and Zimmerman in 1999, as an

interest group, the motivation of the government and government officials to participate in political

activities is to maximize their own interests (Ross L. Watts & Jerold L,2006).Since the rules on tax sharing

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are unilaterally formulated by the government, the government will strive to secure its resources control

right by formulating various regulations including taxation and accounting policy. In a similar way, a

business entity as an economic man aims to maximize its own interests. Therefore, the disagreement

between these two players is quite large.1

In the process of tax collection, on the one hand, the tax authorities collect taxes in accordance with the

existing tax policy; on the other hand, the taxpayers, who perceive their interest loss is greater than the

perceived benefit of “tax’s being used for the people”, will certainly adopt countermeasures to avoid the

excessive interest loss. The empirical studies have shown that in the process of tax planning by Chinese

listed companies, conducting earnings management by selecting different accounting policy to achieve the

purpose of tax avoidance is the primary means being used (Tang,1995). The game relationship between the

tax authorities and taxpayers in the process of tax collection is thus formed, which results in the loss of tax

revenues. The following table shows the estimated loss of tax revenues in the different periods in China by

several scholars:

Table 1 Proportion of Loss of Tax Revenues in China

Scholar Hao Chunhong Wu Yunfeng Dou Xiaoran

Yeas under Study 1996 to 2002 2000 to 2006 2003 to 2009

Amount of Loss of

Tax Revenues

RMB 32.365 billon to

79.286 billion

RMB 426.323 billion to

958.417 billion

RMB 636.5 billion

to 1645.4 billion

Proportion of Loss

of Tax Revenues

1.9% to 11.47% 27.53% to 33.88% 27.64% to 31.8%

The above figures show that the amount of loss of tax revenues in China is high, which represents relatively

high tax risk. The loss of tax revenues is the result of the game between the tax authorities and taxpayers.

The main channel(Meng,2013) used by taxpayers to avoid taxes is so-called underground economy (Zhu

&Yang,2000).2

Analysis from Perspective of Behavioral Economics(Wang,2011)

The prospect theory developed by Daniel Kahneman and Amos Tversky holds that: 1. individuals tend to

be risk averse in a domain of gains; 2. individuals tend to be risk seeking in a domain of losses; and 3.

people are more sensitive to losses compared to gains(Chen,2012). Therefore, when facing gains, people

tend to be very cautious and do not want to take risks; when facing losses, people tend to be less risk averse

and are willing to take risks. The degrees of people’s sensitivity to losses and gains are different. Losses

hurt much more than gains feel good. We are much more sensitive to losses than to gains. And the degree

of people’s sensitivity to loss leads to different behavioral options.

1 Notes: Based on its interest preference, the government will strive to secure its resources control right by formulating

various regulations including taxation and accounting policy. The various damages to the enterprises because of the

existence of political activities are called “political cost” (including rent-seeking cost, tax control cost, and social

contract cost).

2Notes: “Underground economy (Xiaobin Miankun 2000) generally refers to all economic activities that are

out of the government’s regulation, taxation and monitoring, do not pay taxes to the government, and their

output and income are not included into the GDP. From the perspective of taxation, the underground

economy is divided into two types: Type 1 is the illegal economic activity, such as graft, bribery,

embezzlement of state property, producing and selling counterfeited products, smuggling and drug

trafficking, illegal financing, internet fraud, gambling, and money laundering; Type 2 is the legal economic

activity that does not pay taxes to the government, such as unlicensed business activity, concealing income,

and failing to make truthful report of income and tax. The underground economy is the main cause of the

loss of tax revenues and a worldwide problem. The second type of underground economy can be regulated

by institutional adjustment so that the loss of tax revenues will be mitigated and the tax revenues will

increase.

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Figure 1 Value Curve

Near the origin of coordinates, the slope of the gain curve in the first quadrant is different from the slope of

the loss curve in the third quadrant. Under normal conditions, the value function in the gain area is concave

and in the loss area is convex. This indicates that the risk attitudes of a decision maker toward gain and loss

are different, namely, risk aversion in face of gain and risk seeking in face of loss, and people are more

sensitive to losses compared to gains (a < ß), namely, the function in the loss area is steeper than that in the

gain area, indicating that the people’s sensitivity to loss and gain is different. The area between the gain

curve in the first quadrant (red) and coordinate axis represents the change in value when people face gains,

and the area between the loss curve in the third quadrant (green) and coordinate axis represents the change

in value when people face losses. From Figure 1 we can see that the loss area is about three times the gain

area.

To a certain extent, tax is the loss of an enterprise and the economic interest the enterprise has to pay out.

According to the analysis from the perspective of game theory, the enterprise has two strategies in respect

of the tax payment: paying taxes in full amount and evading the payment of some taxes. In choosing tax

evasion, the enterprise faces the risk of the fines being imposed on it. However, according to the prospect

theory, people tend to be risk seeking in the face of loss and they are willing to take risk. Therefore, in the

process of tax game, taxpayers always tend to choose the strategy with higher risk, namely, evading the

payment of taxes. To avoid paying taxes, the taxpayers will manage to reduce the taxable income as

reflected in the tax return to the greatest extent by manipulating accounting information. This will

inevitably result in the distortion of the accounting information.

From the Figure 2 we can observe that, during the period 1990 to 2010, China’s total tax revenues

increased by 25.94 times, of which the domestic VAT revenues increased by 52.73 time, domestic

consumption tax revenues increased by 12.45 times, business tax revenues increased by 21.63 times, and

corporate income tax revenues increased by 17.93 times. These taxes constitute a heavy burden to

enterprises. Therefore, after conducting analysis from the perspectives of conflict, game theory and

behavioral economics, we can find that tax avoidance (i.e. legal tax avoidance) is the best choice of the

enterprises facing huge tax pressure. And this tax incentive augments with the increase in tax burden. The

Figure 2 shows the tax data in China during the period 1990 to 2010.

Loss Gain

Reference

Point

Value

Value Curve

ａ ß

ａrepresents the slope of gain

curve

ß represents the slope of loss

curve

ａ＜ß

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Figure 2 China’s Total Tax Revenues during 1990 to 2010 Data source: China Statistical Yearbook 2011(State Statistics Bureau [SSB], 2011).

Cost Shock

According to cost-benefit theory, any rational agent engaging in economic activity will follow the cost-

benefit principle and avoid loss-leader selling. The expectation that the benefits will outweigh the costs is

the basic starting point that determines people’s behavior and is therefore the primary rational principle of

people’s economic activities (Zhu&Bu, 2011). The recognition and measurement of the corporate

accounting information should follow the cost-benefit principle, that is, the benefits generated by the

accounting information provided by a firm’s accounting department should outweigh the costs incurred in

the process of providing such information (Liu, 2008). The cost constraint condition specifically applicable

to the domain of accounting means that the recognition, measurement and reporting of accounting

information are subject to the double constraints of economic cost and psychological cost. The

improvement in the quality of accounting information needs to restrict the cost constraint to a certain extent

and must avoid unlimited cost increase. The cost constraint comes from two factors: economic cost and

psychological cost.

The economic cost of the accounting primarily refers to the cost of accounting work, namely, the economic

cost incurred in the process of generating accounting information, which should be less than the benefits

generated by the accounting information. Though the high-quality accounting information brings users the

benefits of the reduction in transactions costs such as the costs associated with information search,

identification and validation as well as the improvement in enterprise’ credit rating, the accounting

diseconomy will occur if the economic cost of generating such information outweighs the benefits obtained

by the external users. The accounting costs should be lower than the benefits. For example, the principle of

materiality is the typical compromise strategy under cost constraint.

The psychological cost of the accounting primarily refers to such psychological activity as disgust, pressure

or giving up work of accounting practitioners in the face of an unfamiliar and complex transaction or

business matter such as the asset impairment at the end of a reporting period or calculation of recoverable

amount. The existence of this psychological cost has been confirmed by a number of random surveys of

accounting practitioners (Shenzhen Junhexin Investment Management Consulting Co [SJIMC], 2012). The

quality of accounting information is affected by the cost shock from the subjective and objective aspects,

thus causing the further downward movement of equilibrium point of cost and benefit.

China’s Total Tax Revenues during 1990 to 2010

Total tax

revenues % growth

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Collusion Shock

On the one hand, the finance managers of enterprises as the provider of the enterprises’ accounting

information will generally follow the quality standard of accounting information and provide true

accounting information. On the other hand, as the “rational man” in the market, under certain conditions

they tend to collude with the enterprise’s management for securing their own personal interests. In such a

situation, the distortion of accounting information and the decline in the quality of accounting information

will become a highly probable event. The former may lead to the risk of losing job, while the latter may

bring such benefits of promotion and salary increase. However, the actual behavioral options are not a

subjective behavior, but are intrinsically affected by the interests.

Facing the dilemma of following the accounting quality standards or obeying management’s will, the

accounting practitioners encounter a typical prisoner’s dilemma (Chang, 2006). Obedience is a typical

survival choice, because the economic interest of the accountants is given by the enterprises where they

work and not by the government, and they will certainly be partial to the enterprises.

From the prospect theory of the behavioral economics we can reach the same conclusion: People are much

more sensitive to losses compared to gains. People facing losses tend to be risk averse. So when facing the

risk of losing job and the prospect of promotion and salary increase, people tend to avoid the risk of losing

job. For this reason, driven by the scarcity of professional posts and the maximization of own interests, the

accounts under the survival pressure and interest temptation tend to collude with management rather than to

uphold professional ethics. Under the condition where the agency mechanism is imperfect, the

opportunistic type of accounting policy selection fosters the enterprise managers’ moral hazard and adverse

selection behavior (Christie, Andrew A& Jerold L, 1994). Consequently, when their professional integrity

is under the huge objective pressure, the accountants would certainly choose to collude with the enterprise

management to gain the spillover benefits generated by such collusion. At the same time, lenient

punishment (or legal indulgence) further increases the success rate of collusion.

Results and Analysis

Logical Empirical Analysis

Based on the above understanding of the accounting goal and the realistic constraints on the effectiveness

of accounting information, this paper proposes the following four hypotheses and validates the correctness

of these hypotheses through the empirical data.

Logical Empirical Hypotheses

Hypothesis of Knowledge Shock

The analysis of the knowledge constraint condition reveals that the incompleteness of knowledge comes

from the providers and recipients of accounting information. Facing the ever-changing accounting practice,

the accounting policy makes have to provide the applicable accounting standards in a short time. Therefore,

they must be affected by the knowledge constraint and the accounting standards they provide are not

entirely ideal. On the part of the recipients of accounting information with limited knowledge, they can

only understand the accounting knowledge and conduct accounting treatment according to their

expertise levels and experience. Therefore the results of the accounting treatment ine vitably vary

among these practitioners. These double knowledge constraints lead to the gap between the desired

value and the actual value. On the basis of this, this paper proposes the first hypothesis:

H1: The existence of knowledge constraint results in the fact that the actual quality of accounting

information is below the ideal standard.

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Hypothesis of Interest Shock

The conflict of interest between the providers and implementers of accounting system is primarily reflected

in the economic consequence of the accounting. Specifically speaking, the interest shock is the tax shock.

Because the tax burden of Chinese enterprises is significantly heavy, which constitutes a risk to the survival

and sustainable operations of enterprises, the divergence of the interests of tax authorities and taxpayers

exists and further evolves into the interest game. And because the firms are highly sensitive to the loss (in

the specific situation, to a firm the tax is a expenditure that brings no return and can be considered as a loss)

(Kahneman, 1979), the negative consequence of the games within the rules (e.g. policy implementation

games, looking for and using policy loopholes) would inevitably occur. From common sense we know the

firm’s gaming wisdom outperforms the government’s gaming wisdom. Therefore, through the analysis

from the perspectives of conflict, game theory and behavioral economics, the author of this paper argues

that, when facing the interest shock, firms will take some risk seeking actions to reach the equilibrium point

of the benefits and risks, that is, the shock to the quality of accounting information by the benefits from the

tax avoidance. On the basis of this, this paper proposes the second hypothesis:

H2: Under the circumstances where excessive tax exists, enterprises will try to offset interest shock by

manipulating data of corporate earnings.

Hypothesis of Cost Shock

The behavioral options of the rational behavioral agents in their economic activities are always based on

the measurement of costs and benefits. Only with the expectation that benefits are greater than costs, the

behavioral agents will continue to carry out their economic activities. The consideration of costs and

benefits relating to the provision of accounting information by enterprises is relevant to the economic cost

and psychological cost previously mentioned. The enterprises have the economic incentive to improve the

quality of accounting information only when these costs are lower than the benefits that can be generated

by the accounting information. On the basis of this, this paper proposes the third hypothesis:

H3: Under the cost constraint condition, enterprises will conduct the measurement of accounting

transactions or events by choosing the accounting method of the least cost.

Hypothesis of Collusion Shock

In the real work environment, the temptation of interest has become the variable that affects the behavioral

options of the accounting practitioners. When the temptation of interest is large enough, the orientation of

professional behavior of the accounting practitioners is clearly visible. In the environment where the gains

generated by collusion are much greater than the sanction costs, the collusion becomes the basic behavioral

option of the accounting practitioners as the rational men who are both affected by the scarcity of

professional posts and their own interests. On the basis of this, this paper proposes the fourth hypothesis:

H4: Under the survival pressure and temptation of interest, accountants will collude with their enterprises

to increase the insiders’ benefits.

Variables of Empirical Logic

Explained Variables

The purpose of the empirical logic is to prove the actual gap between the enterprises’ actual quality of

accounting information and the ideal standard thereof, the causes of the gap, and the magnitude of the

various affecting factors. The ideal quality of accounting information is a standard concept, which

possesses two major characteristics: rationality and perform ability. Thus we have the following definition:

The ideal quality of accounting information: represented as 1.

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The actual quality of accounting information: AQ. AQ closer to 1 indicates the higher quality of accounting

information, while AQ closer to 0 indicates the lower quality of accounting information.

Explanatory Variables

(1) Knowledge constraint: The providers and recipients of accounting information are restricted by the

limited knowledge, and this situation is difficult to change, as it is a natural attribute subject to empirical

test. From the time when the accounting information is generated, the account information has been

imperfect, and this situation cannot be changed through repeated measurement. Compared with the

interest shock, the knowledge constraint is difficult to be controlled, and is in the secondary position.

Therefore the impact of the knowledge constraint on the quality of accounting information is less than

the impact of interest shock.

(2) Interest shock: In China, the accounting policy-makers have their specific interest inclination and

political inclination of ensuring the growth of tax revenues, and the tax revenues are the major part of

the fiscal revenues. According to statistics, at least 85% of the annual fiscal revenues are from tax

revenues or the nontax revenues of tax nature. Therefore the State must formulate a series of mandatory

measures to guarantee the collection of tax revenues. As enterprises have to pay more than twenty kinds

of taxes, the real average tax burden of Chinese enterprises is over 40%, which causes the intense

conflict of interest between the enterprises and tax authorities, and “a tension relationship that is caused

by the incompatible interest objectives, judgment of gain and loss or disagreement on gain and loss of

the different interest subjects” (Liu, 1996) as defined by the social conflict theory, conflict refers is

formed. The realistic picture of this tension relationship is reflected in the widespread game strategies,

that is, enterprises employ all available means to avoid taxes. Therefore, this shock has the largest

impact on the quality of corporate accounting information.

(3) Cost shock: Enterprises are willing to maintain the quality of accounting information only when the

benefits brought by accounting are greater than the costs incurred in accounting. Once the difficulty of

accounting increases, and the economic cost and psychological cost are close to or over the benefits

brought to enterprises and individuals by the quality of accounting, the enterprises will certainly reduce

their input and effort to accounting and actively lower the consideration of accounting.

(4) Collusion shock: The corporate accounting information is generated by the enterprises’ accountants

using accounting procedures. Driven by the scarcity of professional posts and the maximization of own

interests, the accounts under the survival pressure and interest temptation tend to collude with

management rather than to uphold professional ethics. In addition, because the economic interest of the

accountants is given by the enterprises where they work and not by the government, with the

subjective will and objective pressure some accountant tend to collude with the enterprise management

to gain the spillover benefits generated by such collusion. To obtain the benefits brought by the

collusion, the collusion involves the concealing, distortion or even fabrication of the economic activity

data to the superior principal (as in the principal-agent relationship). Consequently, the collusion

results in the deterioration of the quality of accounting information (Luo, 2010).

Impacts of Four Shocks

The four shocks mentioned above all have negative impacts on the quality of accounting information to

different extents. Therefore the different weights need to be assigned to these shocks.

Impact of knowledge shock:

The providers and recipients are restricted by the limited knowledge. Because the knowledge is carried by

human being and reflected in people’s mental labor, the knowledge constraint is hard to be directly

measured and can only be measured indirectly. Besides, the knowledge constraint also leads to the

arbitrariness of accounting treatment. For example, a report published by the Institute of Economic

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Observer shows that the best fair bad debt provision ratios should be 5% for the account aging within one

year, 25% for the account aging of one to two years, 50% for the account aging of two to three years, and

100% for the account aging of over three years (Institute of Economic Observer [IOEO], 2006).3 But as

shown in the following table, the actual situation presents a different landscape:

Aging

Structure

Bad Debt

Provision

Ratio

Number of

Companies

Bad Debt

Provision

Ratio

Number of

Companies

Bad Debt

Provision

Ratio

Number of

Companies

Within one

year

5% and

above

779 3% and

below

438 0% 102

One to two

years

25% and

above

36 10% and

below

1121 1% and

below

39

Two to

three years

50% and

above

81 50% and

below

1165 30% and

below

1143

Over three

years

100% 85 50% and

below

718 10% and

below

168

Table 2 The Statistics of the A-share Companies’ Bad Debt Provision Ratios in 2004 by the Institute

of Economic Observer

In addition, the author of this paper holds that the accountants should posses more complex knowledge in

conducting the treatment of asset impairment. But in real work, many accountants do not perform any

treatment of asset impairment due to lack of the relevant knowledge. This leads to the impaction of the

corporate accounting information and reduces the quality of accounting information. In 2003, the Shanghai

Stock Exchange conducted a statistical study on the provisions for asset impairment of 771 companies

listed on Shanghai and Shenzhen Stock Exchanges. The statistical results show that the total provisions for

asset impairment account for 12.4% of these companies’ net profits, indicating a high impact on profits

(Yu&Yu, 2004). Based on the above analysis, the author of this paper conducted a statistical analysis of the

provisions for asset impairment by the listed companies, in order to reveal the impact of the knowledge

constraint on the quality of accounting information. We take 484 companies listed on the main board of

Shenzhen Stock Exchange as a large population. At 5% acceptable risk of overreliance, 10% tolerable

deviation rate and 3% expected population deviation rate, we use sample size table to draw 61 listed

companies4 at random as the sample, and conduct a statistical study of the provisions for asset impairment

by these companies (All data are collected from the official website of Shenzhen Stock Exchange).

3 The Institute of Economic Observer conducted a random sampling survey with 50 samples on the

situation of bad claims of 1284 Chinese A-share listed companies at the beginning of period and the end of

period in 2004. The results show that: In the balances at the beginning of the period of the account

receivables with the aging within one year, 5.41% becomes the account receivables with the aging of one to

two years at the end of period; in the balances at the beginning of the period of the account receivables with

the aging of one to two years, 37.31% becomes the account receivables with the aging of two to three years

at the end of period; in the balances at the beginning of the period of the account receivables with the aging

of two to three years, 52.36% becomes the account receivables with the aging of over three years at the end

of period; in the balances at the beginning of the period of the account receivables with the aging of over

three years, 88.88% has not been recovered at the end of period. The above data fully reflect the increasing

risk of bad debt with the increase in the account aging. Based on the above statistical results and the past

experience of analysis, the Institute of Economic Observer reaches the conclusion on the fair bad debt

provision ratios, namely, 5% for the account aging within one year, 25% for the account aging of one to

two years, 50% for the account aging of two to three years, and 100% for the account aging of over three

years. 4 In statistics, when N>30, a population can be considered as the large population. In conducting sampling ,

the acceptable risk of overreliance should be fixed at a relatively low level, namely, 5%-10%.

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Type of Impairment

Provisions

Provision for

Bad Debt

Provision for

Diminution in Value

of Inventories

Provision for Fixed

Asset Impairment

Other

Impairment

Provisions

Degree of Importance 40 30 20 10

Number of Companies

Drawing Impairment

Provisions

58 33 5 10

Percentage 95.08% 54.10% 8.20% 16.39%

Table 3 Statistics of Impairment Provisions by Companies Listed on Main Board of Shenzhen Stock

Exchange in 2011

After the weighted calculation, the average constraint is:

40*95.08%+30*54.10%+20*8.20%+10*16.39%=57.54. This means the constraint rate of the knowledge

constraint to the sample is 57.54%. According to the law of large numbers, we can infer that the constraint

rate of the knowledge constraint to the population is 57.54%.

Impact of interest shock:

According to statistics, the shares of tax revenues in China’s fiscal revenues during 1995 to 2011are shown

in the following table:

Year Share of Tax Revenues in

Fiscal Revenues

Year Share of Tax Revenues in

Fiscal Revenues

1994 Above 98% 2003 92.18%

1995 96.73% 2004 91.55%

1996 93.28% 2005 90.93%

1997 95.18% 2006 89.79%

1998 93.79% 2007 88.89%

1999 93.35% 2008 88.43%

2000 93.93% 2009 86.91%

2001 93.38% 2010 88.11%

2002 93.3% 2011 86.49%

Table 4 Shares of Tax Revenues in China’s Fiscal Revenue during 1995 to 2011

Chinese enterprises have to pay over twenty kinds of taxes, including VAT, tax for municipal maintenance

and construction, educational surcharges, stamp duty, property tax, operation tax of vehicle and ship, city

and town land use tax, corporate income tax, and so on, in which VAT accounts for 10% of enterprises’

revenues. Enterprises also need to pay additional tax, water construction funds, employee water

construction funds, employee education funds, five social insurances and one housing fund, and disabled

person employment security fund. In total, these taxes account for 30%-40% of enterprises’ revenues

(China Value [CV], 2011). The Forbes Tax Misery Index for 2005 ranked China with the macro tax burden

index of 160 second in the list of countries with heaviest tax systems. Because of such heavy tax burden,

Chinese enterprises could obtain huge potential benefits through tax avoidance, which has great impact on

the quality of accounting information. For this reason, this paper uses the size of the tax burden to measure

the weight of interest shock.

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541

Scholars and institutions have different opinions on the real level of China’s macro tax burden. The

fundamental reason is that they use different calculation methods. In October 2010, Xiao Jie, Director of

State Administration of Taxation(Xiao,2010), based on the data for 2009 and using the statistical criteria of

the International Monetary Fund (IMF) plus government funds and special charges of a tax nature,

calculated the China’s macro tax burden as about 30%. This figure is generally recognized. In 2010,

China’s total fiscal revenues grew by 21.3%, reaching RMB 8.3 trillion, plus the land grand fee of 2.7

trillion. With the GDP growth rate of 10.4%, China’s macro tax burden in 2010 was at least grew by 2%

from 2009. According to conservative estimate, the real level of China’s macro tax burden in 2010 was

32% or more, and in 2011 was 35.96%, as shown in the following table:

Data

in

2011

Tax

Revenues

Nontax

Revenues

Revenues

from

Government

Funds

Revenue

from

State-

owned

Land Use

Right

Revenues

from

Social

Security

Contributions

Revenues

from Central

State-owned

Capital

Operation

Budget

GDP

Data 89720.31 14019.7 8193.39 33166.24 23700 765.02 471564

Table 5 Revenues of Chinese Government in 2011

Unit: 100 million RMB yuan

Total revenues of government=89720.31+14019.7 +8193.39+ 33166.24+23700+765.02= 169564.66

Macro tax burden=169564.66/471564=35.96%

The total revenues of government (including six kinds of revenues) are 16.956466 trillion yuan, accounting

for 35.96% of the annual GDP. This means that on the basis of the overall revenues of government, the

current macro tax burden level in China is 35.96%. This paper thus determines the impact of the tax shock

as 35.96%.

Impact of cost shock:

For enterprises the cost control is very important, and almost all enterprises pay much attention to cost

management. In the accounting practice of enterprises, the quality of accounting information disclosure is

greatly affected by the cost of accounting. More adequate information disclosure means higher cost and

higher information rating. Therefore, we can evaluate the shock of cost to the quality of accounting

information through the assessment of the adequacy of the enterprises’ accounting information disclosure.

The Shenzhen Stock Exchange annually evaluates and rates the accounting information disclosure by listed

companies in their annual reports. In 2011, the ratings of accounting information disclosure by 484

companies listed on the main board of Shenzhen Stock Exchange are shown in the following table:

Ratings Excellent Good Pass Fail

Marks 80 70 60 50

Number of

Companies

56 324 88 16

Percentage 11.57% 66.94% 18.18% 3.31%

Table 6 Ratings of Quality of Accounting Information Disclosure by Companies Listed on Main Board

of Shenzhen Stock Exchange in 2011

By calculation, the average ratings are:

80*11.57%+70*66.94%+60*18.18%+50*3.31%=68.68. The scoring rate is 68.68%. Therefore, the impact

of cost shock is 68.68%.

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542

Impact of collusion shock:

In order to influence investors’ investment behavior and avoid the delisting because of failure to meet the

statutory requirements on corporate earnings, the actual controllers, directors and financial officers of listed

companies would deliberately delay disclosing companies’ relevant information or disclose false

information, such as pending actions, related transactions and corporate losses. To curb the occurrence of

this phenomenon and protect the interests of investors, the stock exchange would establish credit files for

every listed company and record the companies being punished or sanctioned. Therefore, we can determine

the weight of the collusion shock by finding out the companies committing collusion through looking up

these credit files. After reading the 2011 credit files of Shenzhen Stock Exchange, the author of this paper

finds out that in 484 companies listed on the main board, 19 companies had been punished or sanctioned, of

which 9 companies involved the collusion by directors, secretaries of board and financial officers.

Therefore, the impact of collusion shock to the quality of accounting information is: (484-9)/484=98.14%.

Model Construction of Empirical Logic

Explanation of Shock Models

Model of Knowledge Shock

As noted above, the knowledge constraint comes from providers and recipients of accounting information.

For them this constraint cannot be changed through the repeated consideration of such factors as risk,

benefit, and punishment. In other words, this constraint constitutes a “mechanic damage” to the quality of

accounting information and causes the deviation of the actual quality of accounting information from the

ideal quality.

Model of Interest Shock

When the conflict between the interest of enterprises and the fiscal interest of government occurs and given

the lack of the effective constraint mechanism for government’s fiscal and tax interest, enterprise would

certainly cook the books to obtain the benefits from tax avoidance. The administrative regulations are the

countermeasures to this behavior, including such measures as imposing fines and requiring enterprises to

pay overdue taxes. The primary factor that affects the selection of accounting policy by enterprises is the

consideration of enterprise’s development, while regulatory policy is the secondary factor that affects the

selection of accounting policy by enterprises (Lu, 2006). The punishment warning line as shown in Figure

4 represents the maximum administrative risk that an enterprise can bear.

In an extreme case, some small enterprises do not keep the basic accounting books, let alone maintain the

quality of accounting information. In the model this is reflected by the interest equilibrium line that is

continuously close to the interest axis. In such a case, the quality of accounting information is almost zero,

and the enterprise can gain the largest benefits from tax avoidance. On the other hand, an enterprise

preparing accounting statements fully in compliance with the statutory regulations may lose some benefits

that are otherwise obtainable. In the model this is reflected by the interest equilibrium line that is

continuously close to the horizontal axis. In such a case, the quality of accounting information is in the

ideal state, while the benefit obtained by the enterprise is almost zero. In addition, the benefits from tax

avoidance are obtained be the enterprises at the expense of the quality of accounting information.

Therefore, the interest equilibrium line is a curve with negative slope.

Actual Quality Ideal Quality

Point of Knowledge

Shock

Figure 3 Graph of Knowledge Shock

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543

When the benefit obtained by an enterprise through low-quality accounting information is lower than the

risk it bears, the risk constraint will propel the enterprise to refrain from unethical behavior and to improve

the quality of accounting information. This is reflected in the interest equilibrium line locating above the

administrative warning line. When the enterprise’s quality of accounting information is improved to a point

that causes the lost benefit larger than risk, the enterprise will take the risk of avoiding tax in its business

operations. This is reflected in the interest equilibrium line locating below the administrative warning line.

Finally, the actual quality of accounting information will be inferior to the ideal quality as a result of the

constant weighing of risk and benefit by the enterprise. In such a case, the point of interest shock is the

point where benefit equals risk, namely, the shock of interest to the quality of accounting information.

Model of Cost Shock

Point of Cost

Shock

Cost Equilibrium Line

Actual Quality

Figure 5 Graph of Cost Shock

Cost

Cost<Benefit

Cost>Benefit

Break-even Line

Ideal Quality

Point of Interest

Shock

Actual Quality

Figure 4 Graph of Interest Shock

Punishment Warning Line

Interest<Punishment Risk

Interest>Punishment Risk

Interest

Ideal Quality

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544

In providing accounting information, enterprises must pay cost. However, once cost exceeds benefit,

enterprises will stop paying cost. In Figure 5, the break-even line represents the maximum cost that an

enterprise can pay in improving the quality of accounting information.

When the enterprise pays no cost, no accounting information can be obtained. Therefore, the cost

equilibrium line affecting accounting information is a curve starting from the origin. With the increased

cost inputs, the quality of accounting information will also continue to improve to a certain extent.

Therefore, the cost equilibrium line is a curve with positive slope.

The improvement in the quality of accounting information will bring some benefits to the enterprise, such

as more financing and stronger social recognition, When the cost incurred by the enterprise in providing

accounting information is less than the benefits that can be obtained, it is worthy for the enterprise to input

more cost. This is reflected in the cost equilibrium line locating below the break-even line. When the cost

increasingly grows but the growth of benefit becomes less and less, the benefit obtained by the enterprise

cannot cover the cost. In such as case, it is not worthy for the enterprise to input more cost. This is reflected

in the cost equilibrium line locating above the break-even line.

Finally, the actual quality of accounting information will be at the point where cost equals benefit as a

result of the constant weighing of cost and benefit by the enterprise. In such a case, the corresponding

shock point represents the shock of cost to the quality of accounting information.

Model of Collusion Shock

The model of collusion shock is very similar to the model of interest shock. However, because the benefits

that could be obtained from collusion are limited, compared with the shock of tax interest, the impact of the

collusion on the behavior of securities investors has a much smaller impact on the final net profits of

enterprises. For this reason, the slope of the collusion equilibrium line is less than the slope of interest

equilibrium line, and the impact of collusion on the quality of accounting information is smaller. This can

explain why only less than 10 companies in 484 companies listed on the main board of Shenzhen Stock

Exchange have committed the act of collusion to gain improper interests.

In addition, the collusion shock also involves the weighing of the benefits that could be obtained through

collusion and the risk of punishment after the collusion has been found. This is also very similar to the

model of interest shock. But one thing should be noted that the benefits that could be obtained from

collusion are from the act of delaying information disclosure or making false information disclosure. This

is different from the interest shock.

Ideal Quality

Point of Collusion Shock

Actual Quality

Figure 6 Graph of Collusion Shock

Punishment Warning Line

Collusion Interest<Punishment Risk

Collusion Interest>Punishment Risk

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Collusion

Interest



545

Construction of Comprehensive Model

The comprehensive impact of these four kinds of shocks on the quality of accounting information is shown

in the following figure:

The above Figure 7 shows the comprehensive impact of knowledge shock, interest shock, cost shock and

collusion shock on the quality of accounting information. From this Figure we can observe that the

combined effects of interest shock, cost shock and collusion shock result in the gap between the actual

quality of accounting information and the ideal quality. But the final actual accounting information is also

affected by the knowledge shock, which further widens the gap between the actual quality of accounting

information and the ideal quality.

Estimation of Actual Quality of Accounting Information

The logical analysis of the impacts of four kinds of shocks on the quality of accounting information and the

model construction reveal that each shock has different impact on the quality of information, and the

weights of these shocks are different. Therefore, we adopt the weighted average methods to measure the

actual quality of accounting information.

Firstly, we define the vector of weight as W=(W1, W2,W3, W4), with ∑Wi=1(i=1,2,3,4). The vector of the

impact of these four shocks is defined as A=(A1，A2，A3，A4). Thus the actual quality of accounting

information is:

AQ=A*W=(A1, A2, A3, A4)*

Through the normalization treatment of the data regarding the impacts of these four shocks, we obtain the

weights of four shocks: 260.32

Actual Quality Ideal Quality

Interest Equilibrium Line

Point of Shock

Collusion Equilibrium

Line

Cost Equilibrium

Line

Interest/

Cost/

Collusion

Interest

Knowledge Stock

W1

W2

W3

W4

Figure 7 Graph of Impact of Four Shocks

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546

(1) Weight of knowledge shock=98.14%+68.68%+35.96%+57.54%

57.54%=22.10%

(2) Weight of interest shock=98.14%+68.68%+35.96%+57.54%

35.96%=13.81%

(3) Weight of cost shock=98.14%+68.68%+35.96%+57.54%

68.68%=26.38%

(4) Weight of collusion shock=98.14%+68.68%+35.96%+57.54%

98.14%=37.71%

i.e. W=(W1 ,W2 , W3 , W4 )=(22.10%,13.81%, 26.38%, 37.71% )

A=(A1, A2, A3, A4)=(57.54%, 35.96%, 68.68%, 98.14%)

Based on the formula AQ=A*W, we estimate the actual quality of accounting information as 72.81%.

Through the above logical reasoning and model construction, we can observe that because of the impact of

these shocks, the actual quality of accounting information is only equivalent to 71.78% of the ideal quality

of accounting information.

After conducting the fairness assessment of the semi-annual reports published by 114 ST listed companies

in 2005, the Institute of Economic Observer found that the total non-recorded accrued losses of these

companies were RMB 10.5394707 billion, and the adjustment rate of the fair pre-tax profit to the book

profit before tax reached 393.95%. The non-recorded accrued losses were almost four times the book profit

before tax. This indicates that there is great space for improving the fairness of the accounting information

disclosed by companies (Institute of Economic Observer [IOEO], 2005). Thus it can be seen that the

estimated figure in this paper, namely, the actual quality of accounting information equivalent to 72.81% of

the ideal quality, is a rather conservative figure.

Conclusion and Limitations

Relavant Conclusions and Judgments

Through the reasoning of the empirical logic developed in this paper, we can draw the following

conclusions:

(1) In the four negative variables that restrict and damage the effectiveness and quality of accounting

information, each variable has different degree of impact. The interest shock has the largest negative impact

on the effectiveness and quality of accounting information, followed by knowledge constraint, cost shock,

and collusion shock.

(2) The knowledge constraint has the historic limitations. Its damage to the effectiveness and quality of

accounting information should be considered in the course of history and cannot be changed through the

weighing of the relevant factors.

(3) The impact of each of three variables (i.e. interest, cost and collusion) the effectiveness and quality of

accounting information has an equilibrium point, which means the degree of the damage of these three

factors to the effectiveness and quality of accounting information.

(4) Because of the interaction and co-existence of a number of affecting variables, there exists no ideal

quality of accounting information. In the real world, the actual state of the quality of accounting

information is always below the ideal standard of the quality of accounting information. The estimated

figure in this paper, namely, the actual quality of accounting information equivalent to 71.78% of the ideal

quality, is a rather conservative figure.

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547

Limitations of the Study

In this study, there are several limitations listed below:

(1) Due to the lack of the systemic and public sources of direct data, we can only look for the data scattered

on various media. Because the direct evidence is difficult to obtain, we have to use the indirect evidence.

(2) With respect to the sources of weight data, more affecting factors should be taken into consideration and

the more representative sample size is needed. For instance, in the ratings of the quality of accounting

information given by the Shenzhen Stock Exchange, cost is not the only factor that affects the quality of

accounting information, but in this paper we do not take other factors into consideration; knowledge

constraint does not only affect the provisions for asset impairment, and more aspects should be considered.

(3) No empirical study is done. This paper only selects four kinds of logical evidence (interest, knowledge,

cost and collusion), and uses the logical reasoning method to validate the existence the logical empirical

hypotheses. No study of the relevant empirical data has been performed.

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